New Bank Rule: Sounds Boring, Actually A Big Deal

We don't hear much about bank liquidity, partly because it sounds so dull. It's much more fun to talk about prop trading (fear the London Whale!) or structured finance (synthetic CDOs are crazy!).

But if you're trying to figure out how safe banks are — and how willing they'll be to make loans to ordinary people — liquidity is at least as important as other, more-dramatic-sounding corners of finance.

So the new liquidity rules global banking regulators released yesterday are a big deal for the real economy.

Liquidity, in this context, basically means how easy it is to turn stuff you own into cash. Example from ordinary life: Apple stock is very liquid (you can sell it at a moment's notice with no trouble); a house is not very liquid (it could take months to sell and is a huge hassle).

Here's why liquidity is so important for banks.

When people start to panic about the financial system, they have a tendency to go to the bank and ask for their money back. This is especially true of big institutions whose money is not protected by deposit insurance.

Banks, of course, don't keep huge piles of cash sitting in the vault. Instead, they make loans and buy bonds (which are a kind of loan). If a lot of people want to pull their money out of the bank at the same time, banks typically have to sell off some of those bonds.

But not all bonds are created equal. At moments when the finance world seems scary — the kind of moments when people start pulling lots of money out of banks — no one wants to buy bonds that are backed by questionable mortgages, or bonds sold by heavily indebted companies. Everybody wants to buy really safe bonds, like short-term U.S. government bonds.

If you wanted a bank to be really, really liquid, you could say: Take all the money people deposit in your bank, and use it to buy short-term U.S. government bonds. That way, if things get crazy, you can always sell off the bonds and give people their money back.

But if banks did this, they wouldn't have any money left over to lend to ordinary people or small businesses or anything. It would be a disaster for the economy.

You want banks to hold enough liquid assets to weather a crisis, but not so much that it stifles lending to ordinary people and businesses. And so you end up in the rather unsatisfying universe where lots of bank regulation questions seem to end up, trying to work out the details and figure out which way to move on the spectrum of more restrictive or less restrictive.

The rules were initially supposed to kick in in 2015; instead, they will be phased in gradually and won't fully take effect until 2019. And rather than being restricted to government bonds and other supersafe assets, banks will now be allowed to count some riskier assets toward their liquidity requirements.

Banks had pushed for the liquidity rules to be looser than those described in the initial proposal. arguing that looser rules would allow them to make more loans, which would help the economy. That's likely to be true. Banks are, after all, still in the business of making loans; they make more money lending money to ordinary people than they do buying government bonds.

At the same time, there will surely come another day when people start to panic again about the health of the world's banks, and big institutions rush to pull their money out. The looser liquidity rules mean the banks will be in a much riskier position when that day comes — especially if it comes before 2019, when the new rules fully take effect.